Key Takeaways:

• Stock options grant the right to buy shares at a fixed price
• Vesting schedules determine when options become exercisable
• Exercising can be done with cash, cashless, or immediate sale
• Value depends on stock price vs. strike price
• ISOs and NSOs differ mainly in tax treatment 

Stock options let employees buy company shares at a fixed price. They vest over time, can be exercised with cash or cashless methods, and are taxed differently depending on whether they are Incentive Stock Options (ISOs) or Non-Qualified Stock Options (NSOs).

Employer stock options can be complex. A stock option gives employees the right to buy company shares at a pre-set price, often below the current market price. Key considerations include what stock options are, how they work, and how to estimate their value.

The initial public offering (IPO) market has surged to levels not seen since the dot-com boom, and more than twice as many companies listed in 2021.¹ For employees at companies that issue stock options, understanding how they work is important for evaluating their place in a long-term financial plan.

What are stock options?

Stock options are probably the most well-known form of equity compensation. A stock option is the right to buy a specific number of shares of company stock at a pre-set price, known as the “exercise” or “strike price.” Employees take ownership of granted options over a fixed period of time called the “vesting period.” When options vest, they are considered earned, though they must still be purchased.

How do stock options work?

Stock options are commonly used to attract prospective employees and to retain current employees.

Stock options may incentivize prospective employees with the possibility of owning company shares at a discounted rate compared with buying on the open market.

The retention of employees who have been granted stock options occurs through a technique called vesting. Vesting helps employers encourage employees to stay through the vesting period in order to take ownership of the options granted to them. Options are not considered fully owned until the requirements of the vesting schedule are met.

For example, assume you have been granted 10,000 shares with a four-year vesting schedule of 2,500 shares at the end of each year. This means you have to stay for at least one full year in order to exercise the first 2,500 options and must stay to the end of the fourth year to be able to exercise all 10,000 options. In order to receive your full grant, you typically have to stay with your company the full vesting period.

Exercising and selling stock options

Options cannot be exercised until they are vested. 

There may be some agreements that can accelerate the vesting schedule (e.g., in the event of an acquisition), but these are rare. And there are also time limits on when you can exercise or access your options – they typically expire between 5 to 10 years after the date of grant. If an employee leaves the company before vesting, unvested options are typically forfeited.

How to exercise stock options

Once you are ready to exercise your options, you typically have several ways of doing so:

1. Cash payment: Employees may use cash to exercise the options at the strike price.
2. Cashless exercise: Some employers allow employees to exercise options by selling just enough shares to cover costs of exercising others.
3. Cashless exercise/sale: Some employers allow employees to exercise and immediately sell options at the current market price, which means you won’t have any ongoing exposure to any stock price volatility, and you won’t have to come up with any cash up front to exercise.

How to calculate what your stock options are worth

There is a relatively simple way to determine what your stock options are worth: If the stock is worth $25/share, and your strike price is $20, then your options will be worth $5 each.

For employees at pre-IPO companies, it can be difficult to determine the future value of stock options because the eventual share price is unknown.

Another important point to note when evaluating your options is that they have little to no value unless the share price is greater than the exercise price. If options are exercised and the stock price decreases, the employee may lose both the amount spent on exercise and any associated taxes. All of these factors mean stock options (and all forms of equity compensation in general) create more risk than just getting paid in cash.

How are stock options taxed?

There are two common types of stock options: ISOs (Incentive Stock Options) and NSOs (non-qualified or non-statutory stock options). The main difference is how they are taxed. With NSOs, you realize ordinary income when you exercise your options, based on the difference between the fair market value (FMV) and the exercise price. When you sell the shares, any additional gain is taxed as capital gains or losses.

ISOs, on the other hand, aren’t taxed as income right at exercise. Instead, the difference between the strike price and exercise price may cause the Alternative Minimum Tax (AMT) to apply if you hold the shares past year-end. When the shares are sold, they’re taxed at long-term or short-term capital gains rates depending on how long you held them after exercise.  For long-term capital gains treatment, you must hold the shares more than two years after grant and more than one year after exercise. If you sell the shares before either of these holding periods is met, they receive short-term capital gains treatment.

Tax treatment of options can be complex, and outcomes depend on individual circumstances. Individuals may want to consult a financial advisor or tax professional for specific guidance.

The bottom line on stock options

As with any form of employee equity compensation, it’s important to have a holistic understanding of what your stock options are worth and how they fit into your diversified portfolio. Employees take on a speculative position with stock options, so it may be beneficial to work closely with a financial advisor or tax professional when evaluating strategies.

Frequently asked questions

What is a stock option in simple terms?

A stock option gives an employee the right to buy company stock at a fixed “strike price,” usually below the market price, after meeting vesting requirements.

How do stock option vesting schedules work?

Vesting schedules determine when employees gain the right to exercise stock options. Options often vest gradually over several years or at set milestones.

What happens if an employee leaves before stock options vest?

Unvested options are typically forfeited if an employee leaves the company. Vested options may have a limited exercise window, depending on the plan rules.

What is the difference between ISOs and NSOs?

Incentive Stock Options (ISOs) may qualify for favorable tax treatment if holding requirements are met, while Non-Qualified Stock Options (NSOs) are taxed as ordinary income at exercise.

Can stock options expire?

Yes. Stock options usually expire 5–10 years from the grant date if not exercised, or sooner if an employee leaves the company.

How is the value of stock options calculated?

The value equals the difference between the stock’s market price and the strike price. For example, if the market price is $25 and the strike is $20, each option is worth $5.

Are stock options risky?

Yes. If the stock price falls below the strike price, the options may lose value and exercising them could result in financial loss.